Article / 11 May 2017 at 12:30 GMT

What’s wrong with Canadian banks?

Head of Editorial Content / Saxo Bank
Denmark
  • Moody's downgrades 'Big Six' Canadian banks
  • Downgrade reflects private-sector debt, housing fears
  • Canadian housing bubble could spark crisis

Toronto
Toronto's hot housing market continues to sprout ever-larger condo towers, but the developing bubble may be ready to burst. Photo: Shutterstock 

By Michael McKenna

Last night, Moody’s downgraded the Toronto-Dominion Bank, the Bank of Montreal, the Bank of Nova Scotia, the Canadian Imperial Bank of Commerce, the National Bank of Canada, and the Royal Bank of Canada. The move represents a dramatic loss of confidence in Canada’s banking sector as the cited institutions – Canada’s “Big Six” – are responsible for the lion’s share of the country’s banking and hold a combined total of over $3 trillion in assets.

The downgrade came on fears of private-sector debt expansion with Moody’s senior VP David Beattie stating that “continued growth in Canadian consumer debt and elevated housing prices leaves consumers, and Canadian banks, more vulnerable to downside risks facing the Canadian economy than in the past”.

While Moody’s qualified its downgrade with positive language on Canadian banks’ “strong buffers in terms of capital and liquidity”, its move appears near-inevitable in light of soaring housing costs, particularly in the country’s two hottest housing markets of Toronto and Vancouver.

In Montreal, Canada’s second-largest city, a decades-long backdrop of political tensions coupled with the essential separateness of French-speaking Quebec as both an economy and a destination for immigration and foreign capital have combined to rein in housing costs. In English Canada’s fast-growing centres of Hamilton (rapidly becoming a Toronto suburb), Victoria, and Ottawa, however, prices continue to climb.

View from the edge

Today sees Home Capital Group, Canada’s largest non-bank mortgage lender, set to release its first-quarter earnings in the wake of a May 8 statement in which the firm said the balance in its high-interest savings account is expected to slump to $140 million, or 50% lower than just one week prior.

The dramatic decline reflects a run on the embattled lender that saw its Home Trust subsidiary agree to sell up to $1.5 billion worth of mortgages to an unnamed buyer on May 10. In the broader sense, however, it points to a severe loss of confidence in Canadian lenders and in the country’s overheated housing market.

In a warning to clients issued this week, Bank of Montreal chief economist Doug Porter said “let’s drop the pretense. The Toronto housing market and the many cities surrounding it are in a housing bubble”.

One week prior, on May 2, Canada’s Financial Post reminded readers of the collapse of the British and US housing bubbles, quoting Bank of Canada governor Stephen Poloz as stating that “there is no fundamental story that we could tell to justify [the kind of housing price inflation seen in Toronto of late]”.

While qualifying this with a note on the well-managed and well-capitalised nature of Canada’s big banks, author James Saft nonetheless said that “it is hard to look at other housing bubbles and not conclude that once doubt creeps in, the self-reinforcing cycle of borrowers reaching to buy more house and prices rising goes into reverse”.

So is Canada preparing for its version of the 2007-8 subprime crisis?

Similar but different

While any incipient Canadian crisis could not compare in scale to the US subprime event, says Saxo bank head of FX strategy John J Hardy, in relative GDP terms it could shake the Canadian economy even more than 2007-8 did the US.

There are, however, significant structural differences, says Hardy, noting that “the US subprime crisis was especially impactful on US and global markets because of the wide usage of derivatives and the highly leveraged balance sheets of large US financial institutions…it only took a minor correction in housing prices to trigger a massive meltdown.”

“This is not the issue in Canada,” Saxo’s FX head continues, “where mortgages are mostly held on bank balance sheets and lending standards, despite a growing subprime presence, are much tighter.”

That said, Hardy adds, “Canadian house prices have risen even more than US house prices did during the US bubble and the construction sector in Canada’s economy is far larger than it ever was in the US, so the risk is still very large if there is a significant slowdown in housing-related activity and house prices”.

Concentrated risk

Shares of Canada’s Big Six banks have been declining since late-February/early-March as investors spooked by the increasingly obvious housing bubble retreat from the country’s financial sector. Given the concentration of Canada’s financial sphere further weakness or, worse, panic regarding the country’s large lenders represents a very real risk for the Canadian economy.

Royal Bank of Canada (Canada's largest bank) shares are retreating:
RBC

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Source: Saxo Bank 

According to Hardy, “if there is a significant slowdown in housing-related activity and house prices, the financial sector impact could be quite large as housing price declines would lead to impaired mortgage loans, and this would inevitably feed a classic credit crunch”.

While the concentration of Canada’s banking industry may from one perspective point to a certain fragility, however, the fact that Canadians largely see their big banks as quasi-permanent fixtures could make state intervention an easier task than in the US. As Hardy points out, “the Canadian banking sector would likely see large capital infusions from Ottawa if balance sheet risks raise the risk of a credit crunch.”

Whatever the likely policy response, however, Canada appears to be at something of a precipice as multiple factors beyond the troubled housing/debt/banking cluster combine to cloud the country’s outlook. First, the weakness seen in commodities this year continues to weigh on the resource-dependent nation’s economy while the threat of a US recession – a risk John Hardy says is growing as the Federal Reserve continues to normalise policy – could further inhibit Canadian performance.

CAD to $0.65?

As far as the loonie goes, Hardy is wary, noting that “CAD has been rather steeply discounted on the weak outlook, but there could be a 10% further downside risk or even slightly more if fairly bad versions of the risks to Canada play out.”

“Historically, a very weak CAD saw USDCAD above 1.60 and we’ve only seen as high as 1.4600 for this time around,” says Saxo’s head of forex strategy.

As painful as this may be for Canadians cautious of their CAD-denominated pensions, savings, and investment portfolios, further CAD weakness could boost the country’s exports sector… so long as protectionism-friendly president Trump does not erect further barriers.

Even if this proves the case, however, Niagara Falls remains great in the summer, particularly for US visitors enjoying a resurgent currency.

It’s also, it should be noted, a wonderful metaphor.

Niagara Falls
Over the edge? Photo: Shutterstock

Michael McKenna is an editor at Saxo Bank 
2y
djustoe djustoe
Hi Michael,
If i wanted to take a short position on the Canadian property market, is there an ETF / property fund CFD product which saxo offers?
According to this article , Toronto property prices have increased 25% in the past 12 months : http://www.theglobeandmail.com/real-estate/house-price-data-centre-canadian-house-prices-see-record-breaking-month/article29697029/
Is that legit?
2y
Michael S. McKenna Michael S. McKenna
Hi djustoe, there is the iShares S&P/TSX Capped Real Estate Investment Trust Index Fund (XRE.TO) as well as the BMO Equal Weight REITs Index ETF (ZRE.TO). Both can be traded via Saxo's platform.
2y
Michael S. McKenna Michael S. McKenna
As far as the Globe's housing index data go, I have not looked into their methodology but given the paper's Toronto-area prominence, I would be surprised if they are off the mark to any significant degree... too many competitors in town!
2y
djustoe djustoe
thanks v much

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